Covered Interest Rate Parity

The Covered Interest Rate Parity (CIRP) condition* is a rule of thumb on how currency markets function under normal (liquid) circumstances. It became especially relevant during the Financial Crisis of 2007-2009, when it was "broken," implying markets were not liquid anymore. Just a note, I'm not an economist, so feel free to correct me if you are. If you're not, feel free to highlight any bits that sound cryptic.

Covered Interest Rate Parity assumes that, in a liquid market, people specialized in exploiting interest rate differentials between currencies will be able to take full advantage of them. These people are called arbitrageurs. To put it in a somewhat paradoxical way: Arbitrageurs profit from differences in interest rates by lending in a different currency than the one they're borrowing in, and they exploit these differentials until the potential profits are offset by the cost of lending operations.

Thus, as long as they have access to any given currency, arbitrageurs will make sure lending or borrowing in currency A will cost roughly the same as exchanging currency A for currency B and lending or borrowing in currency B. Yet in case of market frictions, arbitrageurs may be rendered unable to access certain currencies, and thus be unable to fully exploit interest rate differentials.

That's why deviations from the CIRP condition imply liquidity shortages and market frictions. During the 2007-09 Financial Crisis, the lack of US dollar funding, especially in Europe, rendered market participants unable to exploit arbitrage opportunities. Accordingly, severe deviations from the CIRP condition were measured for the dollar, indicating high market stress.